MLPs Gaining an Advantage

MLPs Gaining an Advantage

Consistent readers of my musings will hopefully recognize a pattern of forward thinking in what we discuss. An investor who looks at the facts before him and determines the obvious choice will likely face a lifetime of disappointing results and being “outflanked” by those who anticipated the next several moves on the chess board. This often requires some conjecture to gain an advantage.

Since low interest rates have created a competitive landscape for investments with yield, utilities and pipeline MLP (Master Limited Partnerships) shares have garnered quite a bit of investor optimism with their high payout rates. Utility companies such as Centerpoint or Southern Company are rate-regulated providers of power. They almost universally pay attractive dividends on their stocks, with the caveat being that these are very slow-growth businesses. In contrast, MLPs are publicly traded partnerships that look like regular stock shares, but are treated differently for taxes since they are not corporations and are intentionally designed to avoid corporate taxation. They accomplish this by passing through income directly to shareholders (partners) in the form of distributions and not dividends.

MLPs are effectively just another type of utility, since the majority of MLPs are natural gas and liquids pipelines. They charge energy companies a “toll” to pass materials through the line, which is a safer and cheaper way to transport as opposed to trucking and trains. MLPs are generally not rate-regulated like normal utility companies, and MLPs are growing faster than utilities given new gas production techniques and limited pipeline infrastructure.

The relative attractiveness of MLP distributions has created much investor interest, driving share prices generally higher. This has been cause for concern about a bubble being built in the prices of these vehicles. Recent swoons in MLP share prices have been attributed to the possibility that MLPs may lose their favorable tax treatment going forward. I tend to look at this as a possible opportunity instead.

The distributions outlined above receive other favorable treatments as well. The finite life of the underlying MLP asset may allow for depletion or depreciation in such a way that parts of the periodic payments are considered a capital flow and may not be currently taxable at all. Yet, some types of these adjustments simply reduce the calculation for an investor’s original purchase price, which would increase the size of a gain if sold in the future. This is where the advantage may be found going forward. Since current tax-change rhetoric seems determined to reduce the advantage that “ordinary” corporate dividends receive (capped at a 15% tax rate currently), less harsh language is being used with capital gains (also currently 15% for holdings older than one-year). If a large spread exists in the future; say 40% tax on dividends and 20% tax on capital gains, MLP payments that result in reductions in the capital account cost basis could result in both deferral of taxation until sold, and a reduction in rate (20% vs 40%). This currently has the effect of converting a current distribution into a capital gain in the future, where tax rates under discussion currently seem advantaged. If this ordinary income taxation on dividends were to be ratified, MLP share prices would likely move quickly and any advantage would be lost by being last. My favorable outlook is not that MLPs might be treated any more favorably on taxation in the future. It is only by relative comparison that MLPs likely would have no change in their taxation, and that ordinary dividend taxes may rise on regular stocks. This would give MLPs a newfound relative advantage that does not seem to be priced into the marketplace currently. So as you consider the momentum of the impending discussion points, keep this conjecture in mind as you play your pawns.

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